The Meaning, Merits and Demerits of Proportional System of Taxation
The meaning, merits and demerits of proportional system of taxation is one of the major concepts in fiscal policy.
What is the proportional system of taxation?
Systems of Taxation
Systems of taxation describe how the tax burden changes as income changes.
Proportional System of Taxation
A proportional system of taxation is a system in which the same percentage or tax rate is applied to the taxable income of all taxpayers, regardless of the amount they earn.
As income increases, the amount of tax paid also increases, but the tax rate remains constant. For example, if the tax rate is 10%, a person earning ₦500,000 pays ₦50,000, while a person earning ₦1,000,000 pays ₦100,000. In both cases, the tax rate is 10%.
Merits of Proportional System of Taxation
1. It is simple to understand
Under a proportional system of taxation, all taxpayers pay the same percentage of their taxable income. This makes the system easy for taxpayers to understand because they only need to know the fixed tax rate and calculate the required amount. For example, if the tax rate is 10%, a person earning ₦500,000 pays ₦50,000, while a person earning ₦1,000,000 pays ₦100,000. The rate remains 10% regardless of the level of income.
2. It is easy to calculate
The proportional system of taxation makes tax calculations relatively straightforward because the same rate is applied to taxable income. Tax authorities and taxpayers can calculate the amount of tax by simply multiplying the taxable income by the fixed tax rate. This reduces complicated calculations and makes the administration of the tax system easier.
3. It is easy to administer
Since the same tax rate applies to all taxable incomes, tax authorities don’t need to establish many different tax bands or rates. This can reduce administrative difficulties and make the collection of taxes more efficient. It can also make it easier for employers and businesses to calculate and remit taxes on behalf of their workers or customers.
4. It provides certainty to taxpayers
A proportional tax system gives taxpayers a clear idea of the percentage of their income that they are expected to pay as tax. Once the government establishes the tax rate, taxpayers can easily estimate their tax liability. This certainty can help individuals and businesses plan their finances and make better economic decisions.
5. It can encourage investment and economic activity
Because the tax rate remains constant as income increases, individuals and businesses may have an incentive to earn more, invest, and expand their activities. A person who increases their income doesn’t move into a higher tax rate simply because their income has increased. This may encourage entrepreneurship, investment and increased production, particularly where the tax rate is moderate.
Demerits of Proportional System of Taxation
The proportional system of taxation has some important disadvantages:
1. It may not adequately reduce income inequality
Under a proportional system of taxation, all taxpayers pay the same percentage of their taxable income regardless of how much they earn. Although a high-income earner pays more money in absolute terms, the same tax rate applies to everyone. As a result, the system may do little to reduce the gap between high-income and low-income earners. Unlike a progressive tax system, it does not require higher-income earners to contribute a larger percentage of their income.
2. It may place a relatively heavier burden on low-income earners
Even though everyone pays the same percentage, the amount left after taxation may be more difficult for a low-income earner to manage. For example, if two people are taxed at 10%, a person earning ₦100,000 pays ₦10,000, while a person earning ₦1,000,000 pays ₦100,000. The higher-income earner still has ₦900,000 left, while the lower-income earner has only ₦90,000. Therefore, the same percentage can have a greater effect on the standard of living of poorer people.
3. It may have limited redistributive effects
One important function of taxation is to redistribute income and reduce excessive income inequality. A proportional tax system has limited ability to achieve this because the tax rate remains the same regardless of income. It does not place a progressively larger percentage of the tax burden on those with greater ability to pay. Consequently, the government may need to rely more heavily on public expenditure and social programmes to support lower-income groups.
4. It may be less suitable where there are large income differences
In an economy where there is a wide gap between rich and poor, applying the same tax rate to everyone may be considered less equitable. A person with a very high income and a person with a very low income face the same percentage tax rate. The system therefore does not fully reflect differences in taxpayers’ ability to pay. A progressive system may be more appropriate where the government wants taxation to take greater account of these differences.
Summary
The same percentage is paid by all taxpayers.
Example: everyone pays 10% of taxable income.
Simple to understand and administer.
Doesn’t significantly reduce income inequality.
